Tuesday, January 22, 2013

The Fallacy of Market Efficiency (Naked Capitalism)


Why financial markets are inefficient

By Roger E. A. Farmer, Distinguished Professor and Chair of the Economics Department, UCLA. Originally published at VoxEU.
The efficient market hypothesis – in various forms – is at the heart of modern finance and macroeconomics. This column argues that market efficiency is extremely unlikely even without frictions or irrationality. Why? Because there are multiple equilibria, only one of which is Pareto efficient. For all other equilibria, the whims of market participants cause the welfare of the young to vary substantially in a way they would prefer to avoid, if given the choice. This invalidates the first welfare theorem and the idea of financial market efficiency. Central banks should thus dampen excessive market fluctuations.
Writing in a review of Justin Fox’s book The Myth of the Efficient Market, Richard Thaler (2009) has drawn attention to two dimensions of the efficient markets hypothesis, what he refers to as:
  • ‘No free lunch’, what economists refer to as ‘informational efficiency’;
  • ‘The price is right’, what economists refer to as ‘Pareto efficiency’.
My recent research with various co-authors argues that while there are strong reasons for believing there are no free lunches left uneaten by bonus-hungry market participants, there are really no reasons for believing that this will lead to Pareto efficiency, except, perhaps, by chance (Farmer, Nourry, Venditti 2012).
In separate work, I look at the policy implications of this, showing that the Pareto inefficiency of financial markets provides strong grounds to support central bank intervention to dampen excessive fluctuations in the financial markets (Farmer 2012b). These are strong and polarising claims. They are not made lightly.

Read Full Original Post and More HERE

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